Lots of Fuel for Oil Services

September 09, 2004

By Eric Wahlgren Motorists may feel like doing jigs at the pump over the decline in oil prices from record highs reached in late August. But for energy investors, the roughly 10% fall in crude prices from Aug. 20's intraday peak of $49.40 a barrel is a bit of a downer. After all, this year's oil-price spike -- due to growing demand, combined with supply problems in Iraq and elsewhere -- helped power energy stocks to 17.9% gains so far in 2004. The benchmark Standard & Poor's 500-stock index has flatlined over the same period.

Still, at least one group within the sector stands to do well even if energy prices return to more modest levels (see BW Online, 9/9/04, "Are Refiners Losing Power?"). Oil-services and equipment companies that help the private oil majors and state-run energy concerns drill, pump, and perform other key tasks are especially well-positioned to benefit from current trends, investing experts say. "The outlook is the brightest it has been in a number of years," says Robert MacKenzie, a senior analyst with Friedman, Billings, Ramsey & Co. in Arlington, Va.

PRICING POWER. Worldwide crude oil production capacity is near historic lows, MacKenzie says, suggesting that oil-services outfits are going to see increased demand as exploration and production (E&P) companies turn to them to help boost output. In particular, estimates indicate that the world produces only 1.2 million barrels per day over what's consumed, putting the overage at about 1.4% -- the lowest level since 1973. "Services firms are likely going to see the benefits of a lot more spending to help increase excess capacity and bring down prices," MacKenzie says.

In this environment, these outfits are likely to have some pricing power, says Gary Russell, an analyst with Stifel Nicolaus & Co. in Denver. Because of strong oil demand, services providers are already running at more than 90% utilization capacity, he says. "If you want to drill, you're going to have to pay higher prices, and that drives up earnings for services companies," Russell says. Indeed, MacKenzie sees fiscal 2005 earnings for the group of 12 oil-services stocks he covers rising a hefty 33%. In contrast, S&P 500 companies are seen posting 10% higher profits on average next year.

Among MacKenzie's top picks in the sector are Schlumberger (SLB) and Halliburton (HAL), the No. 1 and No. 2 oil-services providers, respectively. He rates both outperform. MacKenzie likes New York-based Schlumberger because it's known for being on the cutting edge of technology. What's more, it derives about 70% of its revenues from outside the U.S., vs. an industry average of 66%, he says, giving it more exposure to faster-growing regions.

BUYING OPPORTUNITY? MacKenzie has a price target of $79 on Schlumberger, suggesting the stock could rise 23% from its Sept. 9 close of $64.09 over the next 12 months. "Their consensus estimates are too low and have to rise," MacKenzie says. Analysts on average expect 2005 profits to grow 23%, to $2.50 a share in 2005, on 7% higher revenues of $12.5 billion, according to Thomson First Call.

As for Halliburton, analysts say negative publicity has depressed its stock price, creating a buying opportunity. The Houston-based outfit is facing probes into why the concern, once run by Vice-President Dick Cheney, won so many lucrative reconstruction contracts in Iraq, among other questions. But MacKenzie says, "their core oil-field services business is doing very well." Halliburton is among the biggest players in the Middle East, giving it great exposure to one of the world's biggest oil-producing regions.

Analysts on average expect 2005 profits to grow 19%, to $1.61 a share, despite 5% lower revenues of $19.3 billion, Thomson First Call says. MacKenzie has a $41 price target on the stock, indicating the potential for 37% appreciation from its $29.91 closing price on Sept. 9. Russell also rates Halliburton outperform.

OTHER BENEFICIARIES. Among the smaller players, Russell favors Houston-based Cal Dive International (CDIS), a marine construction company that manufactures offshore platforms, underwater pipelines, and other products. As crude become harder to find on land and in shallow waters, the search is moving further offshore and into the deep. "Cal Dive has the leading expertise in the deepwater market," says Russell. "Basically, the market is coming to where Cal Dive is positioned."

In fiscal 2005, the outfit is expected to post 14% higher profits of $2.05 a share on 2% higher revenues of $528 million, according to Thomson First Call. Russell rates it market-outperform and has a $38 target price, which suggest 20% appreciation over the next 12 months from its Sept. 9 closing price of $31.77.

Other businesses should also benefit from the move further offshore. Robert Howard, editor of financial newsletter Positive Patterns in Springfield, Mo., likes Houston-based Oceaneering International (OII), which performs maintenance and provides drilling support to offshore facilities. "The big fields that are left are offshore and deep," Howard says. "Doing maintenance on systems out there is really Oceaneering's bread and butter." Fiscal 2005 profits are seen rising 24% to $2 a share on 6% higher revenues of $805 million, Thomson First Call says.

VOLATILE PICKS. In addition, MacKenzie is betting on Chicago-based FMC Technologies (FTI), which makes drilling and production systems for deepwater use. The outfit's 2005 profits are expected to increase 23%, to $1.54 a share, on 9% higher revenues of $2.77 billion. He also rates it outperform and has a $36 price target, which suggests it could rise 14% from its Sept. 9 closing price of $31.49.

Back on land, Howard and Russell are both fans of National-Oilwell (NOI), a Houston-based concern that's a top maker of oil-rig equipment. "Demand for their products is going to increase, and its multiple value will likely grow as a result," says Russell, who rates the business market-outperform. His price target of $38 suggests it could rise 23% from its Sept. 9 closing price of $30.91 in the next 12 months. Analysts expect National-Oilwell's fiscal 2005 profits to climb 67%, to $1.79 a share, on 17% higher revenues of $2.56 billion.

Despite the potential upside to these stocks, investing in them has its risks. Among them, the group tends to be subject to price swings of as much as 3% in a given trading session. "If investors don't have tolerance for this kind of volatility, we would counsel them to stay away," says MacKenzie.

DRILL DOWN. Investors should also be aware of company-specific risks. For instance, Halliburton could have more trouble than expected in clearing up its asbestos liability from some years ago. And while National-Oilwell is seeing growth in its business in Russia and China, both countries could have unforeseen political problems that end up hurting business.

But investing pros argue the potential benefits outweigh the risks. Energy demand continues to grow, especially as oil-thirsty China and other developing nations industrialize. "We're of the opinion that the industry is in the early stages of a cycle expansion," says Russell.

Oil-services companies' stocks may be a good way to play the global energy boom since they can be less sensitive to changes in commodity prices than other energy stocks. But before buying, investors are advised to also drill down and examine the oil-services outfits' fundamentals. Wahlgren is a reporter for BusinessWeek Online in Paris